Why didn’t Sea focus on profitability earlier?

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Last week, Sea’s founder and CEO, Forrest Li, announced that the company’s top management will cease to receive compensation until the business becomes profitable and self-sufficient.

I’ve noticed that whenever I report on Shopee’s astounding growth in the past (like here, just last month), many readers like to point out that it doesn’t mean much since that part of the business was bleeding money, dragging results of entire Sea deep into red territory. Surely, they say, a company losing so much can’t be deemed well-managed.

So, the question today is — why didn’t Sea focus on profitability earlier, in better times? Shouldn’t it have been more frugal in the previous years?

The answer is no, and now’s the perfect opportunity to explain why.

Profit is a dirty word, sometimes

A commonly held belief about business is that companies exist to generate profits. After all, isn’t that the purpose? To invest your own money and time in the business to sell a product or service with a markup, netting you a positive return?

Actually, no, it’s not.

Companies do not exist to generate profits — they exist to maximise shareholder (owner) value.

Now, in many cases, maximisation of the value for the owner is, indeed, a profit from operations. Most small businesses work this way, as people who run them must draw a monthly monetary reward to pay their bills. If they don’t, they can go bankrupt very quickly.

This, however, is the source of the broad misconception about business — most people only ever interact with smaller companies and thus, assume profits matter to all of them. Meanwhile, the definition of value changes with the size of the business.

While a hawker stall, grocery store or a hairdresser work to make money on a regular basis, bigger companies — particularly those which are either listed on stock exchanges or want to be — provide the greatest reward for their owners/shareholders through the value they achieve in the process.

To understand this better, let’s take a look at Amazon, one of the world’s most valuable corporations. As you can see in the chart below, while its quarterly revenues have ballooned over the years, its profits remained almost flat.

The company itself had returned very little cash over 20 years.

Image Credit: Vox

If the company isn’t making money, how can it be deemed a good business? And why on Earth would anybody invest their own cash into it if they can’t partake in the profits?

The answer is found in the second chart below:

amazon market summary
Image Credit: Google

A single share in Amazon in 1997 (adjusted for splits over the years) was worth just US$0.09 the day after the company started trading on Wall Street. Today, even after dropping from last year’s historic highs, that very same stake in the company trades at over US$120 — a return of over 1350 times.

US$1,000 put into Amazon in 1997 would be worth well over US$1 million today, and a million would make you a billionaire (after 20 years of doing nothing, just letting Jeff Bezos run the business).

This is the “shareholder value” that big companies are after. And it is also how they attract investors eager to pour in millions, if not billions, of dollars into their growth.

It is also why Sea Ltd. was, similarly, not preoccupied with turning a profit, but rather, accelerating its growth using funds raised in the open market to fuel it.

Paradoxically, if it was profitable, it would mean the company is run badly because it was not spending enough to gain market share rapidly enough to keep its shareholders (investors) happy. They really don’t care if the financial results show a net profit, because they do not expect to get paid back — they expect their stake to multiply in value.

Why is it important all of a sudden?

You might be a little perplexed right now. I’ve just spent a lot of time explaining why profits don’t matter, just after Forrest Li vowed to make Sea profitable. It doesn’t make any sense!

Bear with me for a while longer, please.

You see, pursuing growth at a loss requires money to cover it. If the company’s coffers are empty, it goes bust — party’s over, everybody can go home, and people running it may often end up in a less hospitable place with lots of metal and concrete.

In order to keep burning cash in pursuit of growth, the business has to raise it. Sea did this last year, collecting US$6.3 billion from selling equity and bonds in September 2021, which followed US$2.6 billion raised in December 2020.

As a result, combined with its previous holdings, Sea had about US$11 billion in cash on hand as of June 2022, which is US$4 billion more than last year.

It may sound like a lot, but at the same time, it reported a net loss of close to US$1 billion for the very same quarter. At this rate, it could be burning US$3 billion to US$4 billion per year, which means its war chest could be emptied within as little as three years (and it’s game over if that happens).

And, unlike last year, it can’t really go back to the stock market to raise more, for three reasons:

  • First of all, as all stocks fell in value, so did Sea, losing 84 per cent off its highs. Raising US$6 billion last September would have equalled just four per cent of the shares in the company. To raise as much today, would require parting with more than 20 per cent of the business.
  • Secondly, the stock market outlook isn’t very positive, so there’s no appetite for major deals among individual and institutional investors alike. While last autumn, financial analysts suggested Sea could trade over US$400 per share, the concern today is it may drop under US$50. This doesn’t have much to do with the company itself — which has continued to grow over the past 12 months — but the unpredictable market conditions it is in (with high inflation pushing central banks to raise interest rates and a possible global recession around the corner).
Shopee's market capitalisation oct 2021
Shopee’s market capitalisation tanked by nearly 84 per cent since its October 2021 high / Image Credit: Google
  • Finally, nobody knows how long these problems may persist. Global uncertainty is at historic highs with war in Ukraine that may be going on for years and enduring supply chain issues (made worse by China’s strict pandemic restrictions) — both of which have elevated the costs of international trade due to resultant high energy prices and high transportation costs. While they remain high, consumer willingness to spend is bound to decrease. None of it is good news for e-commerce, which Sea has been investing in, particularly a platform like Shopee that relies on selling mostly cheap goods at razor-thin margins.

In other words, Sea is heading into a storm not knowing how long it may last and it has only itself to rely on, as it is unable to raise any additional funding until the conditions calm again.

Simply put, it is not profits that the company is suddenly pursuing, but self-preservation (that is essential to its shareholders).

The situation wasn’t helped by the ban on its hit mobile game Free Fire in India — one of its biggest markets — earlier this year, pushing even its profitable digital gaming arm Garena into trouble.

That’s why it now chose to jettison some of its Latin American businesses, lay off staff and forgo paying its top management big bucks in pursuit of saving as much money as it can, while making the most possible out of the markets it is strong in.

Given the circumstances, the most valuable activity for the company’s shareholders is no longer expansion — which is increasingly difficult, given the global conditions — but survival.

Its odds, however, would have been considerably worse if not for the US$11 billion pile of cash, which it would not have accumulated, if it pursued profits over growth during better times.

Featured Image Credit: Michael Petraeus